Wednesday, February 08, 2012

Some Stupid Stuff From David Levine

Suppose you can get people to refer to some theory or principle that you advocate as "Motherhood and Apple Pie". A rather stupid way to argue against opponents is to rely on the mere label. So one can argue against a strawperson - one can say that one's opponents are against motherhood and apple pie. Economists happen to have this nonsensical rhetoric strategy readily available, given some of the names of their models. For example, if one were a fool or a knave, one could say that opponents of Dynamic Stochastic General Equilibrium models all preferred static, deterministic, partial equilibrium models - obviously not as good a thing.

David K. Levine insults the reader's intelligence in this way. He has an article, "Why Economists Are Right: Rational Expectations and the Uncertainty Principle in Economics" (part I, part II) in the Huffington Post. He focuses on the label "Rational Expectations:

"In simple language what rational expectations means is 'if people believe this forecast it will be true.' By contrast if a theory is not one of rational expectations it means 'if people believe this forecast it will not be true.' Obviously such a theory has limited usefulness. Or put differently: if there is a correct theory, eventually most people will believe it, so it must necessarily be rational expectations. Any other theory has the property that people must forever disbelieve the theory regardless of overwhelming evidence -- for as soon as the theory is believed it is wrong.

So does the crisis prove that rational expectations and rational behavior are bad assumptions for formulating economic policy? Perhaps we should turn to behavioral models of irrationality in understanding how to deal with the housing market crash or the Greek economic crisis? Such an alternative would have us build on foundations of sand. It would have us create economic policies and institutions with the property that as soon as they were properly understood they would cease to function." -- David K. Levine

I know of nobody who advocates constructing models based on irrational expectations. On the other hand, I can easily imagine a model in which diverse agents might have different theories of the world and rely on different heuristics. Maybe the agents in such a model might not converge on a single model for the world. (Levine does mention issues of convergence, in a wholly inadequate way, in Part II of his article. Even if one accepted his emotionally-charged story, economists still lack any general argument for convergence to a rational expectations equilibrium.) One might construct such a model of short term interest rates. The equilibrium interest rate at any moment of time would be a balance of bullish and bearish forces.

These are hardly unknown ideas in economics. I am drawing directly on Chapter 12 of Keynes' General Theory of Employment, Interest, and Money. G. L. S. Shackle called this a restless equilibrium. Paul Davidson wrote about human decision-making in an environment characterized by processes, of which some are non-ergodic. Nowadays, one might experiment with implementing agent-based models in computer simulations. I could even cite Brad DeLong, Andre Shleifer, Larry Summers, and Robert Waldmann's work on noise traders. Economists in these sort of traditions are well aware of the impact of economic theory on the behavior of economic agents. They even explain why agents might find it rewarding to knowingly persist in behavior based on assumptions that prices will continue deviating from fundamentals, if the idea of a fundamental price is even coherent. Some somewhere have even talked about "performativity".

In short, Levine has completely failed to grapple with the economics literature at all. He is merely misrepresenting the state of play to a popular audience.

So far, I have not mentioned Levine's rationalization of why economists cannot predict crashes and depressions (or even identify bubbles?). Now, clearly some economists did forecast our current hard times. Steve Keen is probably one of the most well-known. But I'll turn to another incident. On 10 July, K. Bastiaensen, P. Cauwels, D. Sornette, R. Woodard, and W.-X. Zhou predicted a crash of the Shanghai Composite index. They stated the crash, with certain confidence estimates, would come between 17 to 27 July 2009. The China Shanghai composite index was around 3,400 during the week of 27 July. And it was around 2,860 during the week of 31 August, a decline of 16%. According to Levine, these successful predictions are just a matter of those with secret methods sometimes being lucky:

"If I say every year 'there will be a crisis this year' eventually I will be right. If 100 people each pick a different year then one of them is bound to be right. A reliable method of predicting a crisis must be a rule that anyone (or at least anyone with the requisite technical expertise) can apply and reach the same correct conclusion as anyone else using the same method."

I am not totally unsympathetic to the above view. But notice that according to the theory of rational expectations, people with divergent theories, models, and heuristics do not exist. On Levine's view, how can he account for the existence of such a range of predictions? How is it that the agents in the model are possessed of superhuman powers not available to mere mortal economists looking on?

6 comments:

tobin always streesed that rational expectation and market clearing are two differen things. For instance, I can imagine a "classical model" in which effective demand determines output; yet I don`t see why such models is incompatible with RATEX.

By the way, I have a (rather lengthy) critique of Levine's attempt to defend REH on my blog:http://larspsyll.wordpress.com/2012/02/14/david-k-levine-is-totally-wrong-on-the-rational-expectations-hypothesis/